1. Understanding Economics
5th edition by Mark Lovewell
Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

2. Understanding Economics 5th edition by Mark Lovewell
Chapter 7
Economic Welfare and Income Distribution
Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

3. Learning Objectives After this chapter you will be able to:
understand the concepts of consumer surplus and deadweight loss, and explain how these concepts can further our understanding of the operation of markets
distinguish spillover costs and benefits and the ways that government addresses these issues
summarize how income is distributed among Canadian households, how this distribution is measured, and the factors underlying this distribution
identify the causes of poverty and the way poverty is measured
evaluate the effectiveness of government intervention to change the distribution of income
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4. Marginal and Total Benefit
Both consumers and producers gain from market activity.
For consumers, these gains can be measured by marginal and total benefit.
Marginal benefit is the extra satisfaction, expressed in dollar terms, from consuming a certain unit of a product.
Total benefit is the total satisfaction, expressed in dollar terms, from consuming a product.
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5. Consumer Surplus (a)
Consumer surplus shows the extent to which consumers pay a lower price than the highest one they are willing to pay.
It is defined as the net benefit, expressed in dollar terms, from buying a product at its market price.
It is found, either for an individual or in an entire market, by subtracting total expenditure from total benefit.
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6. Consumer Surplus (b) Figure 7.1, page 175
Consumer’s Demand Curve for Pizzas
Consumer’s Demand
Schedule for Pizzas 16
A+B = Total Benefit
B = Total expenditure
Price
($ per pizza)
Quantity Demanded
(D)
(pizzas)
Total Benefit
($) 14 12
A = $6 10 D
Price ($ per pizza) 8
$14 1
12 2
10 3 14
26 ( )
36 ( ) 4
B = $30 1 2 3 4
Quantity (pizzas per week)
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7. Consumer Surplus (c) Figure 7.2, page 176
Market Demand Curve for Pizzas
Market Demand Schedule
for Pizzas
A+B = Total Benefit
B = Total Expenditures 18 16
Price
($ per pizza)
Quantity Demanded
(D)
(thousands of pizzas) 14 12
A = $400,000 10 D
Price ($ per pizza) 8
18 0
14 50
10 100 6 4
B = $1 million 2 50 4
Quantity (thousands of pizzas per week)
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8. Producer Surplus
Producer surplus shows the extent to which producers receive a price different from the lowest one they are willing to accept.
It is defined as the difference between the price received from selling each unit of a product and the marginal cost of producing it.
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9. Producer Surplus for a Market Figure 7.3, page 17718 16 14 S 12 10
Price ($ per pizza)
C = $ 8 6 4 D 2 50
100
Quantity (thousands of pizzas per week)
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10. The Case of Perfect Competition
In a perfectly competitive market, the requirement of marginal-cost pricing is met.
Based on this requirement, equilibrium will occur where marginal benefit equals marginal cost, and both consumer surplus and producer surplus are maximized.
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11. The Case of Perfect Competition Figure 7.4, page 17818 16 14 12
Consumer Surplus 10
Price ($ per pizza)
Producer Surplus 8
Marginal Benefit 6 4
Marginal Benefit
Marginal Cost
Marginal Cost 2 D 50
100
150
Quantity (thousands of pizzas per week)
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12. When a Market Becomes Uncompetitive
When a market becomes uncompetitive, for example due to government policy, price rises. The result is that a portion of the consumer surplus becomes producer surplus.
Also there is a net reduction in both the consumer surplus and producer surplus due to the reduction in market output. This net reduction is known as the deadweight loss.
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13. When a Market Becomes Uncompetitive Figure 7.6, page 17918 16 14 12 E F 10
Deadweight Loss
Price ($ per pizza) G 8 6 4 2 D 50 75
100
150
Quantity (thousands of pizzas per week)
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14. Spillover Costs (a)
Spillover costs are the negative external effects of producing or consuming a product.
Adding these costs to private costs vertically raises the supply curve.
The preferred outcome is at a lower quantity than in a perfectly competitive market.
Government intervention (e.g. an excise tax) can produce the preferred outcome.
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15. Spillover Costs (b) Figure 7.6, Page 182
Market Demand Curve for Strawberries
Demand and Supply
Schedules for Gasoline S1 S0
2.50
Spillover
Costs,
Excise
Tax
Price
($ per litre)
Quantity Demanded
Quantity Supplied a
2.00
(D)
(S0)
(S1)
(millions of litres)
1.50 b
Price ($ per litre)
$2.50
2.00
1.50
1.00
0.05 4 5 6 7 8 8 7 6 5 4 6 5 4 3 2
1.00
0.50 D 1 2 3 4 5 6 7 8
Millions of Litres
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16. Spillover Benefits (a)
Spillover benefits are the positive external effects of producing or consuming a product.
Adding these benefits to private benefits raises the demand curve.
The preferred outcome is at a higher quantity than occurs in a perfectly competitive market.
Government intervention (e.g. a consumer subsidy) can produce the preferred outcome.
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17. Spillover Benefits (b) Figure 7.7, page 184
Demand and Supply Curves for an
Engineering Education
Demand and Supply Schedules
for an Engineering Education
6000 S b
Tuition
($ per year)
Enrollment Demanded
Quantity Supplied
5000
Spillover
Benefits,
Student
Subsidy
(D0)
(D1)
(S)
4000 a
(thousands of students)
$6000
5000
4000
3000
2000 8 9 10 11 12 10 11 12 13 14 12 11 10 9 8
3000
Tuition ($ per year)
2000 D1 D0
1000 8 9 10 11 12 13 14
Thousands of Students
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18. Canadian Distribution of Income
Canada’s distribution of income can be shown using the Lorenz curve.
This curve is a graph showing the cumulative distribution of income for households categorized into five groups based on their income levels.
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19. Income Distribution in Selected Years Figure 7.8, page 187
Percentage of Total Pre-Tax Income
Received by Each Fifth of Households
Average
Income
(2006)
$13 800
31 800
51 300
77 800
65 500
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Highest 20%
Average of total
1951 4 11 18 23 43
1961 4 12 18 25 41
1971
4 11 18 25 43
1981 5 11 18 25 42
1991 5 10 17 25 44
2006 4 10 16 24 47
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20. The Lorenz Curve Figure 7.9, page 18360 20 40 80
Households (%)
Cumulative Share of
Income (%)
100
Distribution of Household Income
Cumulative Distribution of
Household Income
Share of Income in 2000 (%)
Cumulative Share
of Income
in 2000 (%)
Perfect
Equality d c
Lowest 4
Second 10
Third 16
Fourth 24
Highest 47
Lowest 20% (a)
Lowest 40% 14 = (b)
Lowest 60% 30 = (c)
Lowest 80% 54 = (d)
100% 100 = (e) b
Perfect
Inequality a
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21. Interpreting the Lorenz Curve
In using the Lorenz curve as a distribution measure, it is useful to compare it with curves for two hypothetical economies:
For an economy of perfect quality, where all have identical incomes, the Lorenz curve would be a 45-degree line emanating from the origin.
For an economy of perfect inequality, where one household receives all of the economy’s income, the Lorenz curve would follow the horizontal and vertical axes of the graph.
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22. The Gini Coefficient
The Gini coefficient provides a single numerical measure of income distribution.
It is defined as the area between a Lorenz curve and the 45-degree line of perfect equality, divided by the entire triangular area under the 45-degree line.
The coefficient varies from 0 to 1, with 0 representing perfect equality and 1 representing perfect inequality.
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23. Wage Determinants (a) There are seven main wage determinants:
labour productivity
education
experience
job conditions
regional disparities
market power
discrimination
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24. Distribution of Earnings (2006) Figure 7.10, page 190
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25. Labour Productivity
In any given market, labour productivity determines the wage of that worker.
Labour productivity is defined as output per worker in a given time.
It is the most important determinant of wages.
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26. Education
Education:
usually adds to a worker’s pay but has opportunity costs as well
serves two main purposes (consumption and investment in human capital)
A student will undertake an educational program if its benefits (both monetary and nonmonetary) exceed its opportunity costs.
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27. Education and Average Family Income (2006) Figure 7.11, page 191
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28. Age and Average Income (2006) Figure 7.12, page 192
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29. Labour Unions There are two main types of labour unions:
Industrial unions include all workers in a certain industry.
Craft unions include workers in a particular occupation and restrict who can be members.
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30. Job Discrimination
Job discrimination relates to hiring, wage, and promotion decisions based on criteria other than a worker’s credentials or performance.
Job discrimination can be direct, in which case employees are paid different amounts for substantially the same work.
Job discrimination can also be indirect, involving a discriminatory division of jobs.
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31. Reasons for Income Inequality (Other Incomes)
There are three main reasons for income inequality in addition to wage determinants:
risk-taking
ability
wealth
Wealth is more unequally distributed than income.
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32. Distribution of Wealth in Selected Countries Figure 7.13, page 195
Sweden (1975)
Canada (1984)
France (1986)
US (1986) 10 20 30 40 50 60 70 80 90
Top 1%
Top 5%
Top 20%
Share of Wealth Held by
Top Wealth Holders (%)
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33. The Poverty Line
The poverty line is the income level below which a household is classified as poor.
In Canada, a household is considered to be poor if it spends more than 63% of its after-tax income on food, clothing, and shelter.
In dollar terms, the poverty line depends on the number of household members and the size of the community they live in.
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34. The Poverty Line for Various Households (2006) Figure 7.14, page 197
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35. The Incidence of Poverty (a)
Poverty rates are higher among unattached individuals than among families, except for lone-parent families with a female head.
Unattached females have particularly high poverty rates as well.
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36. The Incidence of Poverty (b) Figure 7.15, page 198
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37. The Canadian Welfare Society
A welfare society is one in which the government plays a major role in attempting to ensure the economic well-being of its citizens.
Transfer payments and personal income taxes are the most important elements of Canada’s welfare society.
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38. Transfer Payments and Income Equity (a)
Transfer payments are now usually based on the principle of means testing rather than universality.
Transfer payments are greatest as a percent of income for the poorest fifth of households, but the second-poorest fifth of households receives the largest share of these payments.
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39. Transfer Payments and Income Equity (b) Figure 7.16, page 201
Average Transfer
Payments
Received
(2006)
$7 200
9 700
8 400
7 500
5 100
7 600
Transfer Payments
as a Percent of
Total Income
(2006)
51.9%
30.6
16.4
9.7
3.3
11.6
Share Received
of Total Transfer
Payments
(2006)
19.9%
25.7
22.2
19.8
13.3
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Highest 20%
Average of Total
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40. Principles of Taxation
There are two main principles of taxation:
benefits received (e.g. gasoline taxes for roadwork)
ability to pay (e.g. personal income tax)
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41. Taxes and Income Taxes are related to income in three possible ways:
progressive taxes (which increase as a proportion of income as income rises)
proportional taxes (which stay constant as a proportion of income as income rises)
regressive taxes (which decrease as a proportion of income as income rises)
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42. Taxes and Income Equity
Personal income taxes are progressive, with the proportion of income paid in tax rising significantly with a household’s income level.
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43. Personal Income Taxes and Income Equity (2006) Figure 7.17, page 203
Average Personal
Income Taxes
Paid $
2 800
6 700
12 600
33 300
11 200
Personal Income Taxes
as a Percent of
Total Income
5.3%
8.8
13.0
16.1
21.8
17.1
Share Paid
of Total Personal
Income Taxes
1.3%
5.0
11.9
22.4
59.4
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Highest 20%
Average of Total
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44. The Doomsday Prophet
Thomas Malthus formulated a theory of population based on two principles:
food increases in an algebraic progression (1,2,3…)
population increases in a geometric progression (1,2,4…)
He predicted that over time population growth would outstrip growth in the food supply with disastrous effects
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45. A Malthusian Time Chart page 209
Year
Food
Population 1 25 2 50 3 4 75 4 8
100 5 16
125 6 32
150 7 64
175 8
128
200 9
256
225 10
512
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46. Wages, Rent, Interest, and Profit (OLC) Rent
Rent is the payment for the use of a productive resource available in only a fixed amount.
Land receives a rent because its supply is perfectly inelastic.
The equilibrium rent for a particular type of land varies with demand for this land (e.g. a rise in the price of beef affects the rent for ranching land).
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47. Demand and Supply Curves for Land
Wages, Rent, Interest, and Profit (OLC) Equilibrium in the Market for Land Figure A
Millions of Hectares
Demand and Supply Curves for Land
Rent ($ per year) 2 1 4 6 8 12 14 3 5 7 9
Demand and Supply
Schedules for Land
(millions of hectares)
Rent
($ per year)
Quantity
Supplied
(S)
Demanded
(D) S 10 e
$14 12 10 8 6 4 5 6 7 8 6 D 6
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48. Demand and Supply Curves for Land
Wages, Rent, Interest, and Profit (OLC) Changes in the Demand for Land Figure B
Millions of Hectares
Demand and Supply Curves for Land
Rent ($ per year) 2 1 4 6 8 14 3 5 7 9
Demand and Supply
Schedules for Land
(millions of hectares)
Rent
($ per year)
Quantity
Supplied
(S)
Demanded
(D0)
(D1) S 12 b 10 a
$14 12 10 8 6 4 5 6 7 8 5 6 7 8 9 6 D0 D1 6
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49. Wages, Rent, Interest, and Profit (OLC) Interest
Interest is related to the supply of capital resources, and can also be viewed as a financial income.
When money is lent, the lender requires repayment not only of the loan principal but also a charge for the use of the money.
Interest is payment for the opportunity cost of the money being used.
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50. Wages, Rent, Interest, and Profit (OLC) The Range of Interest Rates
Four factors affect interest rates:
credit risk
the loan period
collateral
the size of the loan
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51. Wages, Rent, Interest, and Profit (OLC) Profit
Critics of capitalism attribute profit to the power of business owners rather than to their contributions to the economy.
However, profit can also be seen as a return to entrepreneurs for their risk-taking. From this perspective, it is a an essential private incentive for taking risks.
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52. The Role of Labour Unions (a) (Online Learning Centre)
Unions represent members’ interests through collective bargaining. Both unions and employers make collective agreements which bind both parties for a given period.
When agreement is impossible, mediation or arbitration can be used to bring about a settlement.
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53. The Role of Labour Unions (b) (Online Learning Centre)
If no settlement is reached, union members can work to rule, or stage a strike.
Employers may use a lockout to bring about a settlement.
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54. Reaping the Rewards (Online Learning Centre)
David Ricardo developed a theory of rent based on varying grades of land.
According to his theory, a rise in the demand for wheat increases wheat prices and increases rent as poorer land is brought into cultivation.
He predicted that higher wheat prices would lead to higher money wages and lower profits.
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55. Ricardo’s Theory of Rent Figure A
Land Rents per Hectare
Wheat
Price
($)
(when production costs are $100 per hectare)
Grade A
(50 kg
output)
Grade B
(40 kg
Grade C
(20 kg
Grade D
(10 kg C A B D
Grade of Land
Land Rents per Hectare
Wage ($ per year)
100
200
300
400
$400
$ 5 10
150
[($5 x 50) – $100]
400
[($5 x 50) - $100]
100
300
100
not
cultivated
$300
$150
$100
$100 $0 $0
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56. Understanding Economics 5th edition by Mark Lovewell
Chapter 7
The End
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